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Read This Before You Buy Fannie Mae

Fannie Mae stock is extremely cheap, but make sure you understand what you're buying before you dive in.

Fannie Mae(NASDAQOTH:FNMA) can be a tempting stock for investors. Trading at just a fraction of its pre-crisis value, it has a lot of potential for a big payday if things go the right way. However, that's a pretty big "if" at this point. Before you consider investing in Fannie Mae, here's what you need to know.

Know why Fannie Mae is so cheapAt first glance, it may seem strange that a profitable company trades so cheaply. After all, Fannie Mae earned $14.2 billion in 2014, and the value of all of the common shares outstanding is just $3.1 billion. Unfortunately, when something sounds too good to be true, it probably is.

The reason for the cheap price is that (as of now), shareholders aren't entitled to any of the company's earnings. Once Fannie Mae returned to profitability about three years ago, it was decided that 100% of its profits would be diverted to the U.S. Treasury as repayment for the bailout it received in 2008.

Additionally, there has been an ongoing effort in Congress to completely dismantle Fannie Mae. So far no one has been able to agree on much, but if Fannie Mae were shut down, shareholders could be completely wiped out.

Investors are making a good caseA lot of Fannie Mae's shareholders, led by activist investors such as Bill Ackman and Bruce Berkowitz, are challenging the current arrangement, calling it an illegal seizure of profits that should belong to the shareholders. And they make a pretty good case.

First of all, as of this writing, Fannie Mae has paid back $136.4 billion to the Treasury, or $20.3 billion more than it received from the bailout in the first place. However, the money is being counted as "dividends," so the original debt is still outstanding and will remain so indefinitely.

Secondly, there's the argument that if the government didn't want investors to have the potential for profit, why would it allow Fannie Mae's shares to continue to trade? Sure, they were delisted from the NYSE, but that has more to do with the fact that shares were well below $1 for a certain amount of time. Many of Fannie Mae's investors took a chance and bought shares when the company was left for dead. Now that Fannie is profitable again, shouldn't investors get a share of the profits?

Finally, there's a good case to be made that Fannie Mae would be worth much more if it were taken out of conservatorship and allowed to rebuild its capital levels. In a detailed presentation, hedge fund manager Bill Ackman, who owns more of Fannie Mae's common stock than any other investor, made the case that even including the nearly 80% of the stock that the government would be entitled to, shares could be worth between $23 and $47 -- and the government could end up making more than $600 billion. Therefore letting shareholders make some money could be a win-win situation.

But know that your chances of profit are lowIt's tough to make the case that shareholders don't deserve to profit here, but that doesn't necessarily mean they will -- far from it, actually. This will most likely be a drawn-out, uphill battle that could take years to work its way through the court system, and there's no guarantee that the outcome will be in favor of shareholders.

In fact, one judge already dismissed a handful of the lawsuits. And, while there are still some lawsuits pending in front of a different judge, using somewhat different arguments, there's a strong possibility that the outcome will be the same.

Who should invest?An investment in Fannie Mae might make sense from a pure risk-reward standpoint. After all, the current share price is about one-tenth of the low estimate of what shares could potentially be worth. And although the odds of a favorable outcome for shareholders aren't very high, I certainly believe there's greater than a one-in-ten chance.

However, an investment like this is only appropriate for certain people. First of all, before you decide to invest in Fannie Mae, you need to fully understand all of the risks involved -- and the purpose of this article is to help you realize that. There's a distinct possibility that your investment could end up being worthless, so you should not make this investment with money you're not willing to lose.

If you believe in Fannie Mae, there's nothing wrong with making a small, speculative investment if you fully understand what you're getting into. Just realize that investing in Fannie Mae isn't much different from taking your money to a casino; the odds just might be slightly in your favor.

Author

Matt brought his love of teaching and investing to the Fool in 2012 in order to help people invest better. Matt specializes in writing about the best opportunities in bank stocks, REITs, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!
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